The Roadmap, Part VII: Clarity on Gas Prices

A few years ago, a group of experts identified the types of policies that most countries with high growth experiences had implemented, as well as the ones they avoid. Their results, published in “The Growth Report,” are as close to an approachable recipe book on growth as you’re going to find.

This is the seventh part in a series on what Venezuela can learn from that exercise. In Part II, I tackled the importance of inserting Venezuela into the global economy. In Part III, Quico discussed getting the macroeconomic fundamentals right. In Part IV, we looked at why you need a financial system that fosters savings and investment. In Part V, I discussed the importance of letting the market tell you what you’re good at. In Part VI, I made the pleafor political parties to find some sort of consensus as a pre-condition for any strategy to work. Here’s part VII, where I start discussing (to quote Mel Brooks) the things we “oughtn’t to do but we do anyway”.

Turns out the first thing on this list is the policy choice Venezuela is most famous for:

It happens once every few months: a new ranking comes out listing countriesby their internal price of gas, from highest to lowest.

If you’re like me, your eyes automatically veer to the bottom of the list – not to see if Venezuela is listed as the cheapest gas in the world (duh), but to see how wide the gap has gotten.

But there is an interesting tale to be told at the top of the list. Right there, among the countries with the most expensive gas, is Norway. Norway! A major oil and gas producer, like us; unlike us, a modern, civilized society.

By subsidizing energy, the message our economy gets is “invest in energy-intensive industries, because that’s where the money is.” It’s a signal that disconnects our economy from its real advantages.

Norway has really expensive gas because instead of subsidizing energy, they tax the hell out of it. And while taxing energy in a country with lots of it might be counter-intuitive, it makes so much sense it was included in the list of “things to do” by the Commission on Growth and Development, publishers of The Growth Report. Subsidizing energy is at the top of their list of things to avoid.

They don’t beat around the bush: “In many parts of the developing world, energy is subsidized. This is also a mistake. According to research by IMF economists, Indonesia and Yemen spent more on fuel subsidies in 2005 than on health and education combined. Although removing the subsidies is politically difficult, the costs of not doing so are high …”

In other words, removing energy subsidies and replacing them with energy taxes appears to be something countries with high levels of growth do. In spite of this, you would be tempted to be a contrarian on this one, because … why should that be the case? A subsidy on energy, after all, is a subsidy for industry and for consumers. Countries subsidize all sorts of things, and the report certainly does not suggest doing away with all subsidies.

What makes energy subsidies so damn toxic?

First, the strain it causes in our public finances.

Energy is very difficult to substitute away from – your ability to not use as much energy following a price increase is very limited, something we economists like to call having an “inelastic demand.” And when you face a good with inelastic demand, taxes on these goods will bring in lots of money precisely because consumers will not decrease their consumption when they are imposed. It’s the same thing with cigarettes and booze, so not surprisingly many people say modern man is “addicted to oil.”

These taxes can be enormous. In the UK, for example, total fuel taxes amount to 38 billion pounds per year, roughly 7% of total taxation and 2.5% of GDP. Translate that to Venezuela, and we would be talking about $7.5 billion in lost taxes, a massive amount of money. If we add the money we use to subsidize energy, the amounts involved are much, much larger. Failing to be rational on energy simply leaves too much money on the table.

Subsidies on energy also damage our economy because they send the wrong signal on what we should be producing and what we should be consuming.

One of the main uses of the price system is that, when left to operate relatively freely, it tells a society what it should be focusing on. For example, when walnuts are much more expensive than olives, this suggests that resources would be better spent growing walnuts than olives. Company earnings go up, wages go up, collected taxes go up.

When you subsidize energy, this creates a massive, artificial advantage for industries that use energy very intensively – thinks like steel mills, oil refining, and industries that use a lot of air conditioning.

Countries that have shown high growth rates do not subsidize their domestic energy. The evidence on this is fairly overwhelming.

The general point is that industries that rely heavily on energy tend to provide few jobs, unlike other industries that we call “labor intensive” such as textiles.

By subsidizing energy, the message our economy gets is “invest in energy-intensive industries, because that’s where the money is.” It’s a signal that disconnects our economy from its real advantages.

A few years ago, some cattle-raising friends in Santa Barbara told me the story of a rancher who had imported Holstein cows from the Netherlands. The cows were so traumatized by the unbearable heat, the rancher had to install air conditioning units in their stables so that the cows could be more at peace. Do you think such inefficiencies would occur if the rancher had to pay international prices for electricity?

Or take buses. Have you ever wondered why Venezuelan long distance buses are air conditioned down to like 12 below zero? Here’s the little secret: cold air masks odors. Since fuel costs nothing, the extra cost of cranking up the AC and keeping the bus extra cold is lower than the cost of actually cleaning the bus properly. Talk about a perverse incentive: gas subsidies actually make bus owners use diesel as cleaning fluid!

These ridiculous tales of air-conditioned cows and sub-zero buses underscore another point: energy subsidies tell people to consume lots of energy, and this creates huge social costs.

Not only is it inefficient from an environmental point of view – fomenting traffic, pollution, and the like – but it also creates enormous inefficiencies such as the ones highlighted above.

Subsidizing energy means you subsidize demand and disincentivize the supply of the stuff – is it any wonder we are facing massive blackouts and lines at the pump? And think about the havoc these blackouts create on the rest of our economy.

Subsidizing energy also creates huge opportunity costs, symbolized by the things we cannot afford precisely because we are giving people free gas. It’s become a running joke to compare money spent on subsidizing energy as money spent on not subsidizing education and health, but it’s true nonetheless.

Moreover, it’s a terrible way to engage in social policy. People typically claim that gas should be cheap in Venezuela because “there must be some benefit to living in an oil-producing country.” But this is nonsense – the money spent subsidizing energy goes to big industrialists, truck drivers, and your wealthy aunt in El Cafetal that drives an SUV paying practically nothing for gas, while she bangs her pots against the government.

Countries that have shown high growth rates do not subsidize their domestic energy. The evidence on this is fairly overwhelming. It is about time we face the facts and realize that while having cheap gas and low electricity bills is great for your personal finances, it is the road to ruin.

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